The Roth IRA was first introduced in 1997 and has since been a popular tax planning tool for financial advisors and their clients. As while Roth IRA accounts generate tax-free growth and income from retirement savings, making Roth IRA contributions is most beneficial when a client is in a relatively low marginal tax bracket. This is in contrast to deferring pre-tax dollars to a Traditional IRA, which is often most beneficial when a client’s current marginal tax bracket is high (and anticipated future tax brackets are lower). While Roth conversions are often used to transfer Traditional IRA funds into a Roth IRA account, reporting these transactions for income tax purposes can be complicated when the Traditional IRA from which the funds are being transferred include both pre- and post-tax funds.
Although contributions made to a Traditional IRA usually consist of pre-tax dollars (for which taxpayers can take an above-the-line income tax deduction on their tax returns), there are occasions when post-tax dollars are included as well. For instance, nondeductible contributions are made when a taxpayer (or their spouse) is an active participant in an employer-sponsored retirement plan, and their MAGI exceeds the applicable limit for their filing status. Rollovers originating from an employer-sponsored retirement plan can also include after-tax funds if the plan allowed for after-tax contributions.
When Traditional IRA accounts hold both pre-tax and post-tax dollars, the balance will be subject to the “Pro Rata Rule”, which stipulates that, in general, distributions from a taxpayer’s IRA maintain the same ratable proportion of pre-tax and post-tax funds as the taxpayer’s total IRA balance. Which means that distributions from accounts with a mix of pre-tax and post-tax funds cannot be made as solely pre-tax or post-tax and that transferring these distributions into a Roth IRA will need to be accounted for accordingly.
Despite the intricacies of reporting Roth conversions from Traditional IRAs with pre- and post-tax funding, converting Traditional IRA accounts can make sense, especially when a substantial percentage of after-tax dollars are in the Traditional IRA. As while the after-tax contributions themselves will be tax-free, the growth on those funds will be taxable! Therefore, paying tax on the pre-tax portion of the Traditional IRA balance can be worthwhile when considering the tax-free growth of all contributions made to a Roth IRA.
Accordingly, there are few strategies that advisors can use to make Roth conversions more compelling, which can be particularly useful when the Traditional IRA may not (initially) have a large proportion of after-tax funding. For instance, some clients may have access to an employer-sponsored plan that allows for rollovers of IRA funds into the plan. Since IRA-to-plan rollovers are restricted to pre-tax dollars, such rollovers can essentially serve to reduce the pre-tax balance of a Traditional IRA, maximizing the after-tax balance available for the Roth conversion. Importantly, rolling funds back into an IRA from an employer plan, after completing a Roth conversion, should not be done until after the calendar year in which the Roth conversion was carried out, as doing so would result in the basis of the rollover to be included in the converted amount.
Another strategy available to increase the proportion of IRA after-tax dollars is to make a Qualified Charitable Distribution (QCD), as these distributions are restricted to pre-tax dollars from the IRA. Thus, as in the case of rollovers into an employer-sponsored plan, QCDs effectively reduce the pre-tax portion of the IRA account balance, leaving a larger post-tax balance available for Roth conversions.
Ultimately, Roth conversions continue to be a powerful and versatile tool for financial advisors to help their clients mitigate the tax bite from distributions taken from their retirement accounts. By planning around current and expected marginal tax brackets, and by strategizing to isolate the basis of pre-tax dollars in Traditional IRA accounts, advisors can facilitate substantial tax savings for their clients by way of efficient Roth conversions.
When it comes to retirement accounts and taxes, the question isn’t so much whether income tax will need to be paid, but rather, when income tax will need to be paid.
Accordingly, solid tax planning generally means trying to accelerate the taxation of income (that would otherwise be taxable in future years) into the current year when a taxpayer’s marginal tax rate is relatively low, and to use accounts such as Roth IRAs, Roth 401(k)s, and Roth 403(b)s.
This can be accomplished in a variety of ways (e.g., harvesting capital gains, delaying the payment of business expenses by cash-basis taxpayers, etc.), but one of the most common and easiest ways to ‘pull forward’ the taxation of income is through a Roth conversion.
In deciding whether an individual is currently in a ‘relatively’ high or low marginal income tax bracket, the ‘relatively’ is in relation to the marginal rate that would otherwise be paid on the same income, if distributed at a later time (e.g., when distributions are taken to support living expenses in retirement, or when RMDs begin).
Conversely, it typically makes sense to use ‘traditional’ retirement accounts, such as Traditional IRAs, 401(k)s, and 403(b)s, to defer or reduce income in years during which a taxpayer will find themselves paying a relatively high marginal income tax rate.
Of course, when marginal rates are relatively high, accelerating the taxation of income into the current year, when it would otherwise be taxed in the future, and at a potentially much lower rate in that future year, rarely makes sense. Accordingly, the last thing a taxpayer would want to do in most of those situations would be to make a Roth conversion!
In most of those situations… But not all.
Because even in high-marginal-tax-rate years, in situations where a Traditional IRA contains both pre- and after-tax dollars, it can be beneficial to make partially taxable Roth conversions (or, in certain situations, where losses in the IRA cause cumulative after-tax amounts in IRAs to exceed the current cumulative IRA balance, tax-free Roth conversions)… provided an individual’s after-tax dollars make up ‘enough’ of the IRA (as discussed further, below).
How After-Tax Dollars Get Into IRA Accounts
Distributions from Traditional IRAs are typically fully taxable because the distributions most often consist entirely of never-before-taxed income, either contributions for which a tax break was received when those contributions were first made or for earnings on those amounts.
Sometimes, however, a Traditional IRA will contain some amount of after-tax dollars, on which taxes have already been paid. Such after-tax dollars can ‘find themselves’ in a Traditional IRA in one of two ways, either through nondeductible IRA contributions or through the rollover of after-tax dollars from employer plans that themselves had received nondeductible contributions at some point in the past.
After-Tax Contributions Made Directly To Traditional IRA Accounts
More often than not, after-tax dollars in IRAs are the result of one or more nondeductible contributions made to a Traditional IRA.
As while an above-the-line deduction is generally allowed for any contribution to a Traditional IRA, if the IRA owner and/or their spouse is an 'active participant' in an employer-sponsored retirement plan (including defined contribution and defined benefit plans, and SEP or SIMPLE IRAs), and the IRA owner’s Modified Adjusted Gross Income (MAGI) exceeds certain amounts, the ability to deduct the IRA contribution is reduced, or eliminated altogether.
Notably, though, it’s not the ability to make the Traditional IRA contribution that is phased out; rather, it’s merely the deductibility of that otherwise allowable contribution.
Accordingly, if an individual chooses to make a Traditional IRA contribution, but is not able to deduct the full value of the contribution (because of the combination of their income and their [and/or their spouse’s] status as an active participant in an employer plan), then some or all of the contribution will create basis (after-tax amounts) inside the Traditional IRA.
After-Tax Amounts Rolled Over From Employer-Sponsored Retirement Plans
After-tax amounts can also make their way into a Traditional IRA if they are rolled over from an employer-sponsored retirement plan. More specifically, employer-sponsored retirement plans can give participants the opportunity to make nondeductible after-tax contributions to the ‘Traditional side’ of the employer-sponsored plan, provided total contributions to the participant’s account (the after-tax contributions, plus the employee’s salary deferrals, plus employer contributions) do not exceed the IRC Section 415(c) “Annual Additions Limit” which is the limit on the aggregate total of all contributions that go into the retirement plan account (this limit is $57,000 for 2020). Such amounts may have been previously rolled over from those plans to a Traditional IRA.
In practice today, many employer retirement plans simply allow for Roth-style contributions instead for those who don’t want to take advantage of the Traditional plan’s tax deduction and instead would prefer to make after-tax (and future-tax-free) contributions, though technically after-tax contributions to an employer retirement plan can still be relevant because they are able to be made in addition to the salary deferral limits (up to the IRC Section 415(c) limit noted above). Nonetheless, despite being able to do so, many employer-sponsored plans choose not to incorporate an after-tax contribution provision into their plan. In other situations, a plan may allow for such contributions, but the plan’s failure to meet certain testing requirements can keep highly-compensated plan participants from being able to take advantage of such an opportunity.
Traditional IRA Balances With Pre- And Post-Tax Dollars Are Subject To The Pro Rata Rule
The after-tax dollars inside Traditional IRAs represent money that has already been taxed. Thus, when those after-tax dollars are distributed, they represent a nontaxable return of basis.
Unfortunately for IRA owners, though, there is no way to 'reach in' to their IRA and distribute only the after-tax dollars, tax-free. Rather, distributions that are made from Traditional IRAs with both pre- and after-tax dollars consist of a mix of pre- and after-tax dollars, which are subject to what is known as the “Pro Rata Rule.”
Simply put, the Pro Rata Rule says that when a distribution is made from a Traditional IRA that contains both pre-tax and after-tax dollars, the distribution will consist of a ratable (proportionate) amount of each.
So, for instance, if a Traditional IRA consists of 20% after-tax dollars, and 80% pre-tax dollars, then each dollar distributed – including distributions made as a part of a Roth conversion – will generally consist of 20% after-tax dollars and 80% pre-tax dollars.
Example #1: Adam is the owner of a Traditional IRA that has a total balance of $200,000. Over the years, Adam has made a total of $30,000 of nondeductible contributions with after-tax dollars to the IRA.
Thus, a total of $30,000 ÷ $200,000 = 15% of each distribution Adam makes will consist of a return of his after-tax contributions, while the remaining 85% of each distribution will consist of taxable (pre-tax) dollars.
Accordingly, if Adam takes a distribution of $20,000 from his IRA, he can’t just take $20,000 of his $30,000 of after-tax contributions on a tax-free basis. Instead, $20,000 x 15% = $3,000 will be a tax-free return of his after-tax contributions, and the remaining $20,000 – $3,000 = $17,000 will be taxable. Which in turn leaves $30,000 - $3,000 = $27,000 of nondeductible contributions still inside of the IRA.
There is no method available to reach into the account and grab $20,000 as a solely tax-free distribution (from just the $30,000 of contributions made with after-tax funds).
Additionally, it’s important to realize that, unlike pro rata distributions from 401(k) and similar plans, which, pursuant to IRS Notice 2014-54, can be split apart (and thus allowing the pre-tax portion of a distribution and the after-tax portion of a distribution to be sent to separate locations), the pre-tax and after-tax portions of a pro rata IRA distribution are, in essence, ‘stuck’ together.
Accordingly, if portions of the same IRA distribution end up in multiple destinations (e.g., a Traditional IRA, a Roth IRA, the IRA owner’s ‘pocket’), each destination will generally receive a ratable amount of those pro-rata-allocated pre-tax and post-tax dollars.
Example #2: Recall Adam, from the previous example, whose $200,000 IRA balance includes $30,000 (15%) of after-tax funds.
Now, suppose that Adam takes a distribution of $20,000 from his IRA funds. Per the Pro Rata Rule, that distribution will consist of $20,000 x 15% = $3,000 of after-tax funds, and $20,000 - $3,000 = $17,000 of pre-tax funds.
If Adam has $3,000 of that distribution sent (converted) to a Roth IRA and rolls the remaining $17,000 back to a Traditional IRA, in an effort to just convert the $3,000 of after-tax and none of the pre-tax dollars, he cannot choose to allocate the $3,000 of after-tax dollars to just the Roth IRA conversion, making it tax-free.
Rather, 15% of the $3,000 Roth conversion, or $3,000 x 15% = $450 will be a tax-free conversion of after-tax dollars, while the remaining $3,000 - $450 = $2,550 will be pre-tax dollars.
Similarly, of the $17,000 rolled back to a Traditional IRA, $17,000 x 15% = $2,550 will represent after-tax dollars put back into the account, while the remaining $17,000 – $2,550 = $14,450 will be pre-tax dollars.
A High Percentage Of After-Tax Dollars Can Change The "To Convert To Roth Or Not?" 'Equation'
In general, the decision, "To convert, or not to convert," is one that is driven by the expected change in a client’s marginal income tax rate over time. To that end, if marginal tax rates will be lower in the future, it rarely makes sense to pull forward additional income and pay income tax at a higher current tax rate, sooner than otherwise necessary.
That calculus, however, can be changed by the presence of after-tax dollars in an individual’s retirement account. Simply put, the greater the percentage of after-tax dollars in the account (i.e., consisting of contributions made for which tax deductions were not taken), the more it makes sense to convert all or a portion of the account now, even if today’s marginal tax rate is higher – and in some cases, substantially higher – than is expected to be the case in the future.
But why? Why pay tax now, at a higher rate, when you can wait and pay taxes in the future, at a lower rate?
In a word… earnings.
Recall that while the after-tax dollars in a Traditional IRA are tax-free when distributed, the earnings on those amounts will be taxable in the future. By contrast, if the after-tax amounts are converted to a Roth IRA, the future earnings will be tax-free (provided the qualified distribution rules have been met).
And when a conversion is made from an IRA containing both pre-tax and after-tax dollars, for every $1 of taxable income generated due to the conversion (i.e., from withdrawing pre-tax funds from the Traditional IRA to deposit into the Roth IRA), there is future tax-free growth in the Roth IRA on some amount greater than $1 (where the exact amount depends on the ratio of pre-tax-to-post-tax dollars in the IRA account)!
Example 3: Wendy is a 40-year-old IRA owner with an $80,000 IRA balance. She is currently in the 35% income tax bracket and expects to have a marginal income tax rate of closer to 25% in retirement. Wendy is a diligent saver, has other assets, and hopes to be able to avoid taking distributions from her retirement accounts until she is 70 years old.
In general, the projected decline in Wendy’s projected marginal rate between now and retirement would be a strong contraindication for making a Roth conversion now. But suppose that, of the $80,000 balance Wendy’s Traditional IRA, 40% of that balance, or $32,000, consists of after-tax dollars. That additional information should materially change the thought process.
Think, for a moment, about what would happen if Wendy does not convert, and follows through on her plan of not touching her IRA funds until she is 70 years old. Ignoring any future contributions Wendy might make, if Wendy were able to achieve a 7% annual rate of return (on her current $80,000 balance), she’d have just under $609,000 in her Traditional IRA at age 70.
Despite the sizeable increase in total account value, though, ‘only’ $32,000 – the same amount as today – would represent after-tax funds that will ultimately be distributed tax-free.
Meanwhile, as shown in the chart below, over the 30-year period, taxable earnings of more than $211,000 will have accumulated that are attributable to the $32,000 of present-day, nontaxable after-tax funds in Wendy’s Traditional IRA.
Consider, however, what would happen if Wendy bucked conventional wisdom and converted today, at her higher marginal income tax rate.
True, she’d be paying a higher income tax rate on the taxable $48,000 of the conversion than she’d otherwise have in retirement, but only 60% of the total $80,000 conversion balance would be taxable!
Meanwhile, Wendy would enjoy tax-free growth on the entirety of the converted amount.
Stated differently, for every $1 of pre-tax money converted today (and for which Wendy will owe income tax at her present high income tax rate), 67 cents ($0.67 is 2/3 of $1, reflecting the proportion of 40% of after-tax and 60% of pre-tax funding in the account) of ‘bonus’ after-tax money will be ‘dragged along’ into the Roth IRA too. And once there, the earnings on the full $1.67 will be tax-free!
So, the key question for a client such as Wendy becomes, “Is it worth it to pay ordinary income tax on $1 today to have tax-free growth on $1.67?”
Notably, there is no ‘magic threshold’ or ratio that makes a conversion 'right' or 'wrong' for all clients, all the time. In other words, it’s not as simple as saying, “If at least 20% (or 30%, 40%, etc.) of an IRA is after-tax money, then it should be converted to a Roth IRA.”
Rather, each client’s situation must be evaluated separately, taking into consideration not only the ratio of pre-tax to after-tax dollars in the IRA, but also the expected difference between the current and the future marginal income tax rates (the lower the potential difference, the more a conversion today makes sense), and the length of time until the after-tax amounts would otherwise be distributed (the longer the time, the greater the potential for taxable earnings to accrue on the after-tax dollars and, therefore, the more a conversion today makes sense).
Of course, in situations in which there is either an extremely high percentage of pre-tax dollars or after-tax dollars in a Traditional IRA, the decision-making process is significantly simplified.
For example, if a Traditional IRA contains 99% pre-tax dollars and just 1% of the funds are after-tax, the “To convert to Roth or not?” decision is not really impacted. 1% of a conversion tax-free just isn’t enough to move the needle, and the decision will be driven ‘as normal’ by evaluating current versus future tax rates (and converting to a Roth whenever the tax rate will be lower). On the other hand, if a Traditional IRA were somehow comprised of 99% after-tax dollars and only 1% pre-tax dollars, it would be about as close to a no-brainer “Convert!” decision as there is, regardless of how much higher today’s marginal income tax rate is compared to the projected future marginal rate, as nearly all of the growth will simply be converted from taxable to tax-free! Unfortunately, though, real-world client situations are often more complicated.
Isolating Basis Using Roll-Ins Into Employer Plans
But what if there was a way to reduce the amount of pre-tax dollars (only) in a client’s Traditional IRA, such that the Roth conversion decision became much easier (because afterward, a greater percentage of the IRA was comprised of after-tax dollars)?
Well, while not every client will have such an opportunity, for many clients, there is a way in which financial advisors can help them do just that!
More specifically, clients may be able to increase the percentage of the after-tax dollars in their Traditional IRA by completing a partial rollover of IRA funds into an employer-sponsored retirement plan, or by using Qualified Charitable Distributions (QCDs).
In both instances, an exception applies to the Pro Rata Rule, enabling the distribution to consist of entirely pre-tax funds (leaving a greater percentage of after-tax funds behind)!
For some lucky retirement savers with access to an employer-sponsored retirement plan, the complications of the IRA Pro Rata Rule can be completely eliminated. If the plan allows participants to roll in ‘outside’ (non-plan) funds, the taxpayer can take advantage of a ‘glitch’ in the Internal Revenue Code ‘Matrix’.
More specifically, while the Pro Rata Rule generally applies to IRA distributions (including amounts being rolled over), after-tax amounts are not eligible to be rolled from IRAs into employer-sponsored retirement plans! Accordingly, when distributions from a Traditional IRA are rolled into an employer-sponsored retirement plan, the IRS treats the rollover as consisting entirely of pre-tax dollars (to the extent such funds existed as pre-tax dollars in the Traditional IRA in the first place), because the after-tax dollars aren’t allowed to come along for the rollover ride even if they wanted to!
Using this tactic, an IRA owner can essentially ‘vacuum’ out their pre-tax IRA dollars, leaving only their after-tax IRA dollars behind in the IRA. Those remaining after-tax dollars can then be converted, tax-free, to a Roth IRA, once all the pre-tax dollars have been safely sequestered inside of an employer retirement plan!
Example 4: Ben is an IRA owner who is also a participant in a 401(k) plan that allows rollovers into the plan. His total IRA balance is $350,000, of which $40,000 are after-tax contributions.
Ben is currently in the 24% ordinary income tax bracket, and he expects to be in the 12% income tax bracket in retirement. As such, an IRA-to-Roth IRA conversion would generally be inadvisable at this time.
Ben, however, can take advantage of his 401(k)’s provision allowing rollovers into the plan, and the exception to the Pro Rata Rule that IRA-to-plan rollovers enjoy.
More specifically, Ben can rollover the entire account balance less after-tax contributions, for a total of $350,000 – $40,000 = $310,000, from his Traditional IRA, which represents the total of pre-tax funds accumulated in the account. Although such a distribution would normally be treated as consisting of a ratable amount of pre-tax and post-tax dollars, since the rollover destination is Ben’s 401(k), and after-tax dollars are not allowed to be rolled into such accounts, the entire $310,000 amount will be treated as consisting of pre-tax dollars!
And with $310,000 of pre-tax funds ‘siphoned’ out of the Ben’s IRA, the $40,000 left will consist entirely of after-tax dollars, which can then be converted to a $40,000 Roth IRA, which is a tax-free conversion since all of the remaining IRA dollars are entirely after-tax!
As a general rule, when IRA rollovers occur – including Roth conversions that are effectively just rollovers to a Roth IRA – an ‘Aggregation Rule’ applies that requires all pre- and after-tax dollars from all accounts to be included in the calculation. However, the Aggregation Rule is only for IRAs, and does not include employer retirement plans. As a result, not only does rolling over pre-tax dollars from a traditional IRA to an employer retirement plan separate out the pre- and after-tax dollars, it specifically collects the pre-tax dollars in an employer retirement plan that does not have to be aggregated with the IRA for Roth conversion purposes, ensuring that the strategy works!
Returning Pre-Tax Dollars Back To The Traditional IRA Without Creating Unintended Pro Rata Complications
Many times, retirement savers like the idea of isolating their Traditional IRA basis via rolling their pre-tax dollars into an employer-sponsored retirement plan (often for purposes of a Roth IRA conversion, but sometimes, just to distribute from the Traditional IRA tax-free), but they don’t really want to keep the rolled-in funds in the plan. Rather, for a variety of reasons (e.g., expanded investment options, more flexible distributions provisions, etc.), they prefer to somehow get those funds back into an IRA.
Fortunately, in many situations, this is possible… provided the individual waits the appropriate amount of time, as discussed further below.
The first caveat is simply that to roll the dollars from the employer retirement plan back to the IRA, the plan participant must be permitted to take dollars out of the 401(k) plan in the first place. If a plan participant has already separated from service, distributions from the employer-sponsored plan are generally allowed. Whether a participant who is still working for the company sponsoring the plan will be allowed to take an in-service distribution is ultimately a plan-level decision; however, most plans that allow rollovers into the plan will allow those same rollovers to be distributed back out of the plan at the participant’s discretion.
The Internal Revenue Code rules regarding distributions from employer-sponsored retirement plans generally prevent a pre-59 ½ employee from being able to access plan funds. Those restrictions, however, do not apply to funds that are rolled into the plan. Such amounts may – at the plan’s discretion – be allowed to be distributed from the plan at any time. But the ability to distribute those dollar amounts is still subject to the plan’s discretion to permit such distributions or not, and thus requires looking to the plan document to see if doing so is possible. (Of course, it will always be possible to reunify the dollars in the long run, simply by waiting until separation from service or age 59 ½!)
In order to avoid Pro Rata Rule complications, though, this option (to roll the funds rolled-in to an employer-sponsored retirement plan back out at any time) cannot be exercised until the calendar year after the left-behind-after-tax-IRA funds are converted to a Roth IRA.
This is necessary because the Pro Rata Rule ultimately calculated on IRS Form 8606, Nondeductible IRAs, uses the year-end Traditional IRA balance.
As such, rolling pre-tax funds out of an employer-sponsored retirement plan and into a Traditional IRA in the same calendar year as an IRA-to-Roth IRA conversion will cause those (plan-to-IRA) rolled-over pre-tax funds to be included in the IRA Pro Rata Rule used to calculate the tax-free portion of the IRA distribution that was converted to a Roth IRA earlier in the year!
By contrast, rolling funds out of an employer plan and into a Traditional IRA in the calendar year after an IRA-to-Roth IRA conversion is completed (or anytime thereafter) will not cause the same complications.
Example 5: Recall Ben, from the previous example, who rolled the $310,000 in his Traditional IRA to his 401(k) plan in order to isolate the $40,000 of after-tax money in his IRA to complete a tax-free Roth conversion in March of this year. Suppose that Roth conversion was subsequently completed on September 1, 2020.
Now, imagine Ben, unaware of the pro rata complications outlined above, rolls the $310,000 back out of his 401(k) and to his Traditional IRA on December 1, 2020.
Despite the fact that there were no pre-tax dollars in Ben’s IRA at the actual moment of his September 2020 Roth conversion, the $310,000 of pre-tax money in his Traditional IRA at year-end (assuming no gains/losses) will be included in the pro rata calculation of that distribution.
Accordingly, only $40,000 (after-tax Roth conversion amount) ÷ $350,000 (total amount of IRA funds, including the $310,000 pre-tax rollover) = 11.43% of Ben’s Roth conversion will be tax-free, meaning that of the original $40,000, only $4,572 will be considered tax-free with the remaining $35,428 being taxable!
If, on the other hand, Ben had waited just one additional month, and completed the same rollover in January 2021 (the calendar year after completing his IRA-to-Roth IRA conversion in December 2020), the entire conversion would have been a tax-free conversion of after-tax funds.
Sometimes, timing really is everything!
Notably, IRS Notice 2014-54 authorized the after-tax portion of a plan distribution to be separated from the pre-tax portion of such distributions, allowing each to be sent to a separate destination. Which in the past might have meant rolling over the pre-tax portion to a traditional IRA, and keeping the after-tax dollars in a checking account for a retiree to spend. But for those who don’t yet need the money, it’s also now an option to roll over the pre-tax portion to a Traditional IRA, and roll over the after-tax portion… to a Roth IRA (as a tax-free Roth conversion!).
Thus, while distributions of after-tax funds from an employer-sponsored retirement plan are still technically eligible to be rolled into a Traditional IRA, that should no longer be done! Instead, IRS Notice 2014-54 allows those amounts to be separated out and rolled over separately, and consequently, such amounts should be rolled over into a Roth IRA, effectively engaging in a tax-free Roth conversion and allowing future growth to be (potentially) tax-free as well (instead of having future growth still being taxable, as would be the case if it were rolled into a Traditional IRA).
Qualified Charitable Distributions (QCDs) Can Be Used To Increase The Percentage Of After-Tax Dollars In An IRA
As discussed above, the most effective way for retirement savers to isolate basis in a Traditional IRA is by rolling the pre-tax portion of the account into an employer-sponsored retirement plan when possible. Unfortunately, though, that’s simply not an option for most savers either because they don’t participate in an employer-sponsored retirement plan or because the plan that they do participate in does not allow rollovers into the plan.
For savers who lack this option but are at least (actual age) 70 ½ or older, another way to increase the percentage of after-tax dollars in a Traditional IRA is to utilize Qualified Charitable Distributions (QCDs) to give some (or all) of the pre-tax value of the account to a qualifying charity.
QCDs are relevant in this context because, while the Pro Rata Rule generally applies to distributions from IRAs, QCDs are deemed to be made from only the pre-tax portion of an individual’s IRA balance.
More specifically, IRC Section 408(d)(8)(D) states:
“Application of section 72
Notwithstanding section 72, in determining the extent to which a distribution is a qualified charitable distribution, the entire amount of the distribution shall be treated as includible in gross income without regard to subparagraph (A) to the extent that such amount does not exceed the aggregate amount which would have been so includible if all amounts in all individual retirement plans of the individual were distributed during such taxable year and all such plans were treated as 1 contract for purposes of determining under section 72 the aggregate amount which would have been so includible. Proper adjustments shall be made in applying section 72 to other distributions in such taxable year and subsequent taxable years.” [Emphasis added.]
As a result, someone with only a limited amount of pre-tax dollars in a mostly-after-tax IRA could siphon off some or all of the pre-tax dollars with a QCD, and then – similar to the rollover-to-an-employer-retirement-plan strategy, do a Roth conversion on the remainder what would only be after-tax at that point. Or alternatively, even ‘just’ reducing the portion of an account that has a mixture of pre- and after-tax dollars by using QCDs for at least some of the pre-tax dollars can make the Roth conversion math more appealing.
Example 6: Patty is 73 years old and owns a small IRA. Her total IRA balance is $35,000, of which $14,000 consists of after-tax funds. On an average year, Patty, who is in good health, gives $4,000 to various charities, including her house of worship.
Suppose that instead of giving just $4,000 to her charities of choice this year, Patty uses a QCD to make her contributions for 2020 and the next three years. Thanks to the exception to the Pro Rata Rule that QCDs enjoy, the 4 x $4,000 = $16,000 of charitable contributions will come entirely from Patty’s pre-tax IRA dollars.
Thus, after the QCD, her IRA account balance will be $35,000 (original IRA balance) – $16,000 (pre-tax distribution to charity) = $19,000, of which $5,000 will remain pre-tax and $14,000 will still be tax-free.
Even though Patty would still have some pre-tax money in her IRA ($19,000 – $14,000 = $5,000), the percentage of after-tax dollars in her IRA will have jumped from just $14,000 ÷ $35,000 = 20%, to roughly $5,000 ÷ $35,000 = 74%!
Accordingly, a Roth IRA conversion of some, or even all, of the remaining funds will be dramatically more tax-efficient!
Another QCD-like version of this strategy involves Qualified HSA Funding Distributions (QHFDs), which are also exempt from the Pro Rata Rule and are deemed to be made with entirely pre-tax dollars. Such distributions, however, may be made only once by a taxpayer, and are limited to the maximum HSA contribution the IRA owner is eligible to make in the applicable year. Thus, they have minimal planning value.
Limitations Of Using QCDs To Isolate Nondeductible Basis Of A Traditional IRA
Using QCDs to isolate (or increase the percentage) of basis in an IRA has two notable drawbacks compared to isolating basis via a rollover to an employer-sponsored retirement plan.
First, while there is no limit on the amount of pre-tax dollars that can be rolled from an IRA to an employer plan (when the plan allows rollovers into the plan), QCDs are limited to no more than $100,000 annually.
Second, and probably a bigger issue for most, a rollover from an IRA to an employer plan is merely a cosmetic change when it comes to an individual’s accounts – assets are simply being relocated from one account to another with no change in ownership taking place. By contrast, when an individual makes a QCD, the QCD amount is ‘lost’ to charity. Because it really is a charitable donation!
Thus, while using QCDs to (help) isolate basis can be an effective strategy for the charitably inclined, particularly when an individual is willing to be flexible with their gifting schedule, for those savers with no (or smaller) charitable goals, it’s not a viable strategy (as giving away, even pre-tax dollars, is always more ‘expensive’ than paying the tax on converting them!).
In general, Roth IRA conversions are best completed in years when retirement savers find themselves with a relatively low marginal income tax rate. The existence of after-tax amounts in a Traditional IRA account, however, can alter that general Roth conversion guidance.
More specifically, as the percentage of after-tax dollars in a Traditional IRA account increases, the more it makes sense to convert some or all of the account, regardless of the owner’s marginal income tax rate. Because the greater the ratio of after-tax-to-pre-tax dollars in a Traditional IRA, the more after-tax dollars will get ‘dragged’ into the Roth IRA tax-free for each dollar of pre-tax money converted. And once in the Roth IRA, earnings on both the pre-tax and after-tax amounts converted will grow tax-free.
In some situations, IRA owners may have an ability to increase the ratio of after-tax dollars in their account by completing one or more transactions that are exempt from the Pro Rata Rule. Such transactions include both rollovers of pre-tax IRA dollars into an employer-sponsored retirement plan, and the use of QCDs, which by rule are only made from the pre-tax portion of an IRA.
By rolling over the pre-tax portion of an IRA to an employer-sponsored retirement plan that accepts roll-ins, IRA owners can fully isolate their basis and complete tax-free Roth conversions. QCDs, while more limited, can also be an effective method of increasing the percentage of after-tax dollars in an IRA account, making a Roth conversion more tax-efficient.
Ultimately, the key point is that while Roth IRA conversions should generally be made when an individual is in a low marginal tax bracket, if the percentage of after-tax dollars in that individuals IRAs is high enough – either ‘naturally’ or as a result of taking advantage of one or more basis isolating techniques – a Roth IRA conversion can make sense regardless of the tax rate that must be paid on the pre-tax portion of the conversion.